Banking 101 -
A guide to traditional investment strategies
When looking to start investing to grow your wealth, you will soon discover that there are many different investment strategies that you can use, each with their own set of pros and cons. If you are finding it difficult to know which one is right for you and your investment objectives, this basic starter guide can help.
Choosing the best investment strategy
When trying to decide what is the best investment strategy for your investment objectives there are several factors to consider, such as how much time you would like to spend managing your investments, your views on costs and charges and whether you have any strong views or conviction on certain markets over others. It is common for an investor’s strategy to change over time as their circumstances and objectives change throughout their lifetime.
Traditional investment strategies
There is a vast number of ways to approach investing and building an investment strategy and as such, we cannot cover them all here. Instead, we have provided a brief introduction to some of the key themes or considerations.
What is active vs passive investing?
Simply put, passive investment instruments typically include tracker-funds or exchange traded funds which are designed to mimic the returns of a certain index or market (for example, the FTSE 100). Conversely, an Active fund will usually have a fund manager or management team who are aiming to outperform within a given market through stock selection and style bias.
The Passive versus Active debate has been ongoing for many years and is a great place to start in determining the best investment strategy and style for you and your objectives.
Benefits of active vs passive investing
The advantage of passive investments is that they are typically low cost, with some passive exchange traded funds (ETFs)charging less than 0.1% for their ongoing charges. Many investors argue that given the difficulty for active managers to consistently outperform, it is better to save on fund charges and just ‘buy the index’ via a passive investment.
Conversely, many investors choose to employ actively managed funds in their portfolios as they believe that there is value in the expertise of the fund manager. Whilst actively managed funds do typically have higher charges, there is a possibility of the fund outperforming the market and the benchmark if the manager is successful (I.e., If they make the right calls in terms of their stock selection or sector allocation).
It can be argued that whilst with a passive fund, you are almost guaranteed not to underperform relative to the index, you are also guaranteed not to outperform the index. If you are looking to outperform, you will need an active strategy.
In practice, you may decide to use a combination of actively managed and passively managed investment strategies within your portfolio. Using the US Stock Markets as an example, you may choose to use a low-cost ETF to gain exposure to the S&P 500 index – as it is difficult to outperform this index through active management – and then use an actively managed fund to gain exposure to a smaller sector of the market where the manager can add value (e.g., specialised technology managers or smaller-companies funds).
What is value investing?
Value investing is an investment style made famous by investors such as Warren Buffett. The key principle is to identify companies that are undervalued by the market (determined by price) relative to their intrinsic value and to then take advantage of this mismatch between price and value.
Value investing is based on the view that markets will typically overreact to both good and bad news stories in the short term which will result in share price movements that do not reflect the true value of the company. A successful value investor will do a great deal of research to try and determine the intrinsic value of a company. This may include assessing accounts, financial performance, profit, cash flow and revenue as well as assessing the company’s inherent brand, product, target market and any competitive advantages (sometimes called their ‘moat’).
A value investor will use various metrics to measure intrinsic value vs. current price; the most cited is the Price / Earnings ratio. This ratio measures how much investors are willing to pay for a company based on its current earnings. A value investing strategy will typically allocate to stocks with a low- or below-average price/earnings ratio. A value investor is looking to identify companies which have good long-term fundamentals and prospects and then waiting for the right moment to invest in that company at a discounted price (I.e., when the share price is below its intrinsic value).
One of the main advantages of value investing is that when executed successfully, value investing can be extremely profitable and there are many famous value investors that we read about in the press. However, the risks are that if the investor mis-judges the intrinsic value in a company or, simply circumstances change, they may never see the recovery in share price that they are expecting and can get stuck in what is known as the ‘value trap.’
What is growth investing?
Growth investing is a style that looks to identify companies that will grow at an above average rate compared to their peers or the benchmark. Typically, a growth investor will be investing in younger companies who have high expected earnings growth, due to a new product or emerging trend.
Growth investing usually involves looking at rapidly growing industries, or new sectors entirely, where innovative technologies, products or services are being provided. Growth investors look to achieve their returns based on capital, I.e., share price growth during their ownership period, rather than income returns, I.e., via dividends received. Traditional growth stocks will usually have low dividend payments, if indeed dividends are paid at all, as it is expected that profits or surplus capital will be reinvested into the business or into research and development to aid future growth.
Identifying the potential for a company’s future growth (or indeed that of any sector of the market) is difficult. Growth investing will typically use both a qualitative and quantitative approach. Fundamental analysis (I.e., the qualitative data) will usually cover 5 key areas; historic earnings growth, forward earnings growth, profit margins, return on equity and stock performance. The qualitative analysis is opinion-led; the investor’s interpretation of the company potential based on the fundamentals as well as market trends and the growth investor’s view and conviction looking forward.
What is pound cost averaging?
Pound Cost Averaging is a concept whereby you can take advantage of market volatility over time by allocating capital to your investments at regular intervals.
It is a useful strategy for investors who are looking to make regular contributions to their investments as the process helps to smooth out market volatility. Often, investors will worry that it is the wrong time to start investing or to allocate a large amount of capital, or that ongoing geopolitical or economic events are creating short term headwinds and the possibility of market volatility. Pound Cost Averaging takes out the risk of investing on a single day and can therefore ease these concerns.
The concept is as follows:
- An investor has £4,500 available and decides to invest £1,500 per month, buying shares in Company A.
- In Month 1, the share price of Company A is £150 and so the investor buys 10 shares (£1,500/£150)
- In Month 2, the share price of Company A has fallen to £100 and so the investor buys 15 shares (£1,500/£100)
- In Month 3, the share price of Company A has risen to £125 and so the investor buys 12 shares (£1,500/£125)
Over the 3-month period, the investor has purchased a total of 37 shares with an average purchase price of £121.62.
It is important to note that in a consistently rising market, the Pound Cost Averaging approach will not deliver a superior return. In this scenario, investing all funds at the outset would provide the lowest purchase price. However, in a world where it is extremely difficult to time the market and short term returns and volatility can be difficult to predict, the Pound Cost Averaging approach provides structure which, in turn, can help create discipline.
Investing discipline is extremely important; remaining invested when markets are falling can be a difficult concept for many investors and regular investing provides certainty that you are buying more units at the right time (when markets are lower) and fewer units when markets are higher. This disciplined approach is beneficial for any long-term investor and takes out the worry of choosing a single, arbitrary day to invest capital.
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